Oil Market on the Brink of Stability?

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Saturday, July 30, 2016 04.14 PM / ARM Research 

In the continuing review of ARM securities’ core strategy document “Nigeria Strategy Report H2 2016”,  we publish below the review on developments in the global crude oil market over H1 16 and outlook for H2 16. 

Nigeria Strategy Report H2 2016 - Review of Global Economy and Markets

Extending trends in 2015, OPEC’s production tracked higher in H1 2016 (+3.2% YoY to 32.6mbpd) on the back of the inclusion of Indonesian output (700kbpd) after it re-activated membership in December 2015 as well as higher output from Iran and Saudi Arabia. On the other side of the divide, after proving resilient in face of low oil prices, non-OPEC crude oil production caved in H1 16, falling 500kbpd YoY to 57.0mbpd (H2 15: 57.4mbpd). World demand for crude oil rose 1.5% YoY to 95.2 mbpd in H1 16. The rise in global demand was driven by increased consumption in Asia, particularly India and China which combined accounted for over 60% growth. 

Although the global oil market remained in surplus over H1 16, oil prices staged a remarkable comeback to close the half year at $49.68/bbl (+33%) after initially touching 12 year nadir of $27.88/bbl in January—days after the Iranian nuclear sanctions were lifted. 

Going into H2 16, we expect OPEC to continue to boost crude oil production in a bid to maintain its market share, particularly with the breakdown in the oil-freeze deal between some of its members and Russia. On the flipside, we see scope for recovery in non-OPEC supply led by Russia and Canada. For demand, we expect Asia to remain the engine growth of global oil demand, which will continue to be led by India. On balance, the expected recovery in global supply, amidst the drag down in Asian demand by Europe and the US, suggests, unlike the first half of 2016, supply will accelerate at a quicker pace than demand in H2 16. This prognosis, which suggests some widen of the glut, should also drive a pick up in the rate of onshore and floating storage inventory build-up, after the recent decelerations.  

The fundamental outlook which remains bearish for oil prices is compounded by strengthening US dollar on increased Brexit related capital flight, trimming of long positions by money managers as well as increased hedging around the $45- 50/bbl level through to 2017. The latter perhaps signals disbelief on the sustainability of the Q2 16 rally amongst high cost producers. Brent crude prices has averaged $41.9/bbl in H1 16, but based on the foregoing dynamics and historical price movements, we envisage even more pressure could lead prices to trade within the range of $35-$40.00/bbl on average over most of H2 16. 

Resurgence of Iranian output extends OPEC’s record output 

Extending trends in 2015, OPEC’s production tracked higher in H1 2016 (+3.2% YoY to 32.6mbpd) on the back of the inclusion of Indonesian output (700kbpd), after it re-activated membership in December 2015, as well as higher output from Iran and Saudi Arabia. Following suspension of nuclear sanctions in January, Iran ramped up oil output by ~700kbpd to four year high of 3.7 mbpd by June, while Saudi Arabia, in a bid to retain market share, maintained record production levels above 10.2mbpd (+1.4% YoY) over H1 16. These increases offset production pressures in Nigeria, Libya and Venezuela. Combined, these three countries lost over 500kbpd of output versus a year ago, with Nigeria and Libya accounting for nearly 80% of the drop. In Nigeria, production dipped nearly 10% YoY to 1.6mbpd in H1 16 on increased vandalism of oil installation in the oil rich Nigeria Delta by militant groups while blockage of ports by Petroleum Facilities Guard (PFG) militia in Libya saw its output decline nearly 200kbpd YoY to 340kbpd. For Venezuela, weak output (-100kbpd YoY to 2.3kbpd) reflects acceleration in natural declines due to years of under-investment compounded by power crisis and cash crunch. 



Falling US production drag non-OPEC volumes lower

On the other side of the divide, after proving resilient in face of low oil prices, non-OPEC crude oil production caved in H1 16, falling 500kbpd YoY to 57.0mbpd (H2 15: 57.4mbpd). The decline in non-OPEC output primarily stemmed from North America, particularly the US, where increased idling of oil rigs (-79% to 318) following cutback in capex in response to soft oil prices caused production to drop nearly 300kbpd YoY to 9.0mbpd over H1 16. Significantly, US output by the end of June 2016, is 1 mbpd below its peak production same period last year. 

Interestingly, though Canada output remained fairly resilient, with output up 2.2% YoY in Q1 16, wildfires burning through Fort McMurray, Alberta, forced nearby oil sands companies to shut-in 1.2 mb/d of production in early May, dragging H1 output 3% lower YoY to 4.3mbpd. These dips more than offset record production levels of 11.2mbpd (2.3% YoY) in Russia. On aggregate, global crude oil supply was largely flat (+0.4%) at 96.13mbpd in H1 16 (H2 15: 96.7mbpd). 

India overtakes China as driver of global oil demand

World demand for crude oil rose 1.5% YoY to 95.2 mbpd in H1 16. The rise in global demand was driven by increased consumption in Asia, particularly in India and China, which combined, accounted for over 60% growth. In China, though buoyed by government stimulus program, demand for oil rose about 300kbpd YoY to 11.6mbpd in H1 16, it is less than half the YoY growth in the corresponding period of 2015 as the economic continues to slow. Consequently, India’s oil demand growth overtook China for the first time in decades as demand hit a record 4.4mbpd (+400kbpd YoY) in H1 16. India’s strong oil consumption was underpinned by robust vehicle sales—with double digit growth in gasoline and diesel consumption—infrastructure push and government’s LPG penetration scheme. Europe and North America also recorded modest growth in oil demand as low prices continue to buoy motor way miles. Consequently, the quicker growth in global oil demand, relative to supply, resulted in a contraction in global oil glut from H2 15 (~1.3mbpd) to 1mbpd in H1 16 which is about half in the same period in 2015.

Prices rebound as money managers bet big on oil market rebalancing

Although the global oil market remained in surplus over H1 16, oil prices staged a remarkable comeback to close the half year at $49.68/bbl (+33%) after initially touching 12 year nadir of $27.88/bbl in January—days after the Iranian nuclear sanctions were lifted. Oil prices rebounded quite sharply for a number of reasons. 

First, the Iranian return to the oil market was less dramatic than initially feared, with production up only about 220kb/d over February vs. the 550kb/d ramp up within a week which Iranian oil minister had claimed was possible. The slower Iranian output disappointment coincided with a mid-February offer by Saudi Arabia, Venezuela, Qatar and Russia to freeze production at January output levels, even as unexpected supply shocks particularly Canadian wildfires and militant activities in Nigeria added more bullishness. In many ways, the recovery also reflected a bet that on-going rebalancing of global oil market with net long positions of money managers climbing 70% from YE 15 to 318,000 by the end of H1 16 will persist.

  

Global production to accelerate on higher Iranian and Canadian output

Going into H2 16, we expect OPEC to continue to boost crude oil production in a bid to maintain its market share, particularly with the breakdown in the oil-freeze deal between some of its members and Russia. Indeed, signs of this play were visible with Saudi Arabia, the cartel’s largest producer, ramping up production near 2.45mbpd in June even as it cut prices on shipments of Arab extra Light to US, Asia and the Mediterranean. Similarly, Iran would be looking to boost oil production to pre-sanction levels of 3.4 mbpd—that is another 700kbpd increase—after adding nearly 700kbpd over H1 16. We expect increases on these fronts; particularly from Iran to continue to offset civil unrest induced shocks in Nigeria and Libya as well as the natural declines in Venezuela.  

On the flipside, we see scope for recovery in non-OPEC supply led by Russia and Canada. Like other OPEC countries, the breakdown in freeze deal should see Russia continue to fight for market share sustain output around record levels of 10.9mbpd, while Canadian output should recover to prior levels (4.5mbpd) as operators return to Fort McMurray following the cessation of the wild fires. In the US, though we expect the descent in output to persist, the modest rebound in oil prices, but crucially the stability around $45/bbl level, which is encouraging return of some producers to well-pads, suggest the pace of declines could decelerate. Indeed, rig counts have climbed in last 5 of the 6 weeks of H1 16 and producers have increased hedging around current prices with net short positions climbing to four and half year highs late in H1 16. In all, primarily reflecting recoveries in output as Canada and Iran rush back to the market, we expect global oil production to quicken over H2 16. 

Slowdown in European market to taper demand growth

For demand, we expect Asia to remain the engine of growth of global oil demand, which is continually led by India. In addition to robust economic outlook, strong oil demand in India should be buoyed by a filling up of its strategic petroleum reserves (SPR) as the country seeks to hedge against its increasing dependence on oil import. 

For China, while we expect the deceleration in consumptions to continue as the economy continues to cool, the country will remain a major driver of demand over the rest of the year. In the west, particularly Europe, the demand picture is not so rosy as uncertainty around the Brexit vote is likely to compound the flagging demand for oil which should keep a lid on growth. US demand is also expected to slow as energy refiners look to reduce their stock piles which have continued to climb with the glut in the crude oil market. 

More down side risk for oil prices as glut potentially widens over the rest of the year

On balance, the expected recovery in global supply, amidst the drag down in Asian demand by Europe and the US, suggests, unlike the first half of 2016, supply will accelerate at a quicker pace than demand in H2 16. This prognosis, which suggests some widening of the glut, should also drive a pick up in the rate of onshore and floating storage inventory build-up, after the recent decelerations. The fundamental outlook which remains bearish for oil prices is compounded by strengthening US dollar on increased Brexit related capital flight, trimming of long positions by money managers as well as increased hedging around the $45- 50/bbl level through to 2017. The latter perhaps signals disbelief on the sustainability of the Q2 16 rally amongst high cost producers. Brent crude prices has averaged $41.9/bbl in H1 16, but based on the foregoing dynamics and historical price movements, we envisage even more pressure could lead prices to trade within the range of $35-$40.00/bbl on average over most of H2 16. 

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